How federal governments allow banks to create the vast majority of the world’s money supply, and why that erodes the value of money over time.
In this episode you’ll learn:
- What is financial intermediation.
- What is fractional reserve banking.
- How banks create money through creative accounting.
- How banks decide how much money to create through their lending decisions.
- How central banks try to control the amount of lending.
- Why federal governments can create money in theory but don’t do so in practice.
Show Notes
Money creation in the modern economy – Bank of England – Q1 2014
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Summary Article
How Banks Create Money
When I was in college I took a class on banking. One of the exercises was to participate in a computer simulation in which we ran our own banks. Each week a classmate and I would dutifully set our deposit rates and lending rates as we competed with other classmates to attract funds from virtual depositors that we could then use to make loans to willing borrowers.
We learned that banks were financial intermediaries that channeled customer deposits into worthwhile projects initiated by creditworthy borrowers who used those loan proceeds to build buildings, buy equipment, inventory, etc.
Those borrowers would hopefully repay the loans with interest, allowing the banks to make a profit.
Fractional Reserves
This type of financial intermediation made sense to me.
A more challenging topic was the concept of fractional reserves. Banks only had to keep percentage (i.e. 10%) of their deposits readily available in case depositors wanted to withdraw funds. 90% of the deposits were lent. And those loan proceeds after being spent usually ended up as a bank deposit belonging to the person or company who sold the original borrower goods or services.
If a person takes out a bank loan to buy a car then whoever sold the car to the borrower now has the borrowed money that they usually deposit in a bank. That bank after setting aside the 10% reserve could then lend 90% of the new deposit. I remember doing the math that showed how that initial deposit was lent and deposited over and over again, increasing the nation’s supply of money.
How Banking Really Works
I ended up dropping the banking class partway through the academic quarter.
Perhaps had I stayed, the professor would have sat us down and said, “Now that you have learned and practiced traditional banking theory, let me tell you how banking really works. Banks are really just bookkeepers. Creative accountants who can create credit and money out of nothing through the magic of accounting.”
My accounting skills in college were a little shaky. You could often hear me muttering to myself, “Debits and assets on the left. Credits and liabilities on the right,” referring to which side of the ledger or “T account” the digits needed to be placed.
Still, had my professor showed me how banks account for loans and deposits I would have agreed with him. Banks create money out of nothing. Here is how banking really works. It’s all about accounting.
Banks versus Non-banks
If a non-bank company makes a loan, it records the amount of the loan as an asset (i.e. a receivable) on its balance sheet. When the non-bank pays out the loan, its cash balance, which is also an asset on its balance sheet, goes down by the amount of the loan.
The non-bank’s balance sheet doesn’t expand. The company simply swaps a cash asset for a loan receivable asset.
What happens when a bank makes a loan?
The bank also records a loan receivable on its balance sheet as an asset. But here is where things get a little creative. When the loan is funded, the bank doesn’t reduce its cash balance as a non-bank does.
Instead, the bank records a customer deposit as a liability on its balance sheet in the same amount of the loan. That means the bank’s balance sheet expanded by the loan amount.
Creative Accounting
How can the bank do this? Because banks are the accountant of record when it comes keeping track of deposits.
Here is how Richard Werner describes it in his book, “New Paradigm in Macroeconomics:”
“Bank credit creation does not channel existing money to new uses. It newly creates money that did not exist beforehand and channels it to some use. … What makes this ‘creative accounting’ possible is the other function of banks as the settlement system of all non-cash transactions in the economy. … Since banks work as the accountant of record—while the rest of the economy assumes they are honest accountants—it is possible for the banks to increase the money in the accounts of some of us (those who receive a loan), by simply altering the figures. Nobody else will notice, because agents cannot distinguish between money that had actually been saved and deposited and money that has been created out of nothing by the bank.”
Banks create money by altering the accounting records. Non-banks can’t create money when they issue loans because ultimately they have to reduce their cash balances that are on deposit at their bank in order fund the loans.
Because banks are the entities that keep track of deposits, they don’t reduce their own cash balances or someone else’s deposit when they issue a loan. Instead, they create a new deposit that matches the amount of the loan.
Here is how the Bank of England describes the process in its paper, “Money Creation In A Modern Economy:”
“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”
Unlimited Loans and Inflation
Creative accounting means banks can make unlimited loans. While banks have to maintain reserves and adequate capital balances, there is nothing to keep them from raising capital (i.e. equity) by issuing loans to investors who in turn invest in the bank.
The only constraint banks have in making loans and creating money is their willingness to do so and their ability to find creditworthy borrowers.
Given banks create over 90% of the money supply out of nothing is it any wonder that inflation erodes the value of money over time?
Related Episodes
2: What Causes Inflation and Deflation?
162: Is Inflation A Good Thing?
190: How To Keep Up With Inflation
205: Is The Federal Reserve Really Printing Money?
272: Is Inflation Measured Wrong?
